Why the Oil Glut will Continue and How it Benefits Russia

IEA forecasts over-supply and depressed prices for at least a further year. However the Russian economy's performance over the last 10 months shows its resilience in the face of the oil price fall. A period of lower oil prices is anyway arguably necessary to encourage more investment in agriculture and manufacturing

According to the International Energy Agency (“IEA”) the oil supply glut is set to continue until well into 2016.

Inevitably there will be some people who will say that the IEA is deliberately talking down the market so as to encourage a low oil price, which is presumed to be beneficial for Western economies.

What the IEA is predicting however follows the classic pattern of an over-supply glut.

The initial response of producers to a supply glut is to increase rather than cut back production as a way of keeping market share and maintaining cash flow through higher sales. Heavily indebted marginal producers like the shale producers in the US tend to do this to an even greater degree than more established producers, since they have to maintain cash flow to pay their debts.

The result is that as production grows the supply glut increases driving prices down even more.

This is the process the IEA is describing and given the state of the market and the debt financing needs of US shale producers - the weakest link in the industry - it makes complete sense.

Oil is by no means unique in following this pattern. One of the reasons for the “dust bowls” in the US in the 1930s was the removal of top soils by US farmers driven to overproduce in the 1920s by low prices caused by the conditions of over supply created by the preceding period of high prices before and during the First World War.

Falling prices during the supply glut caused by rising production however eventually undermine the position of marginal producers, especially if as US farmers were in the 1920s and as some US shale producers are today, they are heavily indebted.

In the 1930s in the US farm industry there was actually a foreclosure crisis. It is not completely impossible that something similar may eventually happen amongst weaker producers in the US shale industry.

Once the process has finally run its course prices will recover - probably by more than some assume.

The last few months have shown that Russia is capable of weathering the oil price fall. Indeed a period of lower oil prices is arguably beneficial to an economy with low debt that wants to expand its agricultural and manufacturing base. Used properly a period of low oil prices should encourage higher investment in agriculture and manufacturing as opposed to energy, which has had a disproportionate share of investment up to now.

For this period of lower oil prices to be used properly, so that long-term investment in manufacturing and industry become truly profitable, inflation and interest rates need to fall below what have been their historic levels in Russia, which is why the government is so single-mindedly focused on lowering inflation.

The rebalancing of the oil market that started last year has yet to run its course and a bottom in prices “may still be ahead”, according to the world’s leading energy forecaster.

In a bearish assessment of market conditions the International Energy Agency said the adjustment process would “extend well into 2016” as production — led by Opec nations — continued to swell and demand growth softened.

The Paris-based agency, which advises the world’s biggest economies on energy policy, said the oil market was “massively oversupplied”.

Global oil supply surged by 550,000 barrels a day in June to 96.6m b/d, up 3.1m b/d from the same month a year ago, the IEA said in a widely followed monthly report

“The market’s ability to absorb that oversupply is unlikely to last. Onshore storage space is limited. So is the tanker fleet. New refineries do not get built every day,” the IEA said. “Something has to give.”

That something could be US shale oil, the agency said. Relentless supply growth from North America has been one of the factors contributing to the glut in crude oil.

While some weakness in US shale oil output was beginning to show “it may also take another price drop for the full supply response to unfold”, the IEA warned.

Oil prices on both sides of the Atlantic fell sharply this week, with Brent crude — the international benchmark — entering bear market territory. Brent hit $55 a barrel on Monday, rattled by the financial turmoil in Greece and the stock market rout in China. On Friday Brent had risen back to $59 a barrel — a level that is still almost 50 per cent lower than last year’s $115 a barrel June peak.

Cost savings, efficiency gains and hedging have helped shale producers “defy expectations” until now, but supply growth ground to a halt in May and is forecast to stay at these levels through mid-2016, the IEA noted. After growing at 1.7m b/d in 2014, US shale onshore production is forecast to slow to 900,000 b/d this year and 300,000 b/d in 2016.

As a whole, the IEA expects non-Opec supply growth will slow to 1m b/d in 2015 and stay flat in 2016 as lower oil prices and spending cuts take hold.

Although the IEA increased its global demand growth forecast for 2016 to 1.2m b/d — taking total demand to 95.2m b/d — it is still less than 1.4m b/d it predicts for this year.

“World oil demand growth appears to have peaked in the first quarter of 2015 at 1.8m barrels a day and will continue to ease throughout the rest of this year and into next,” said the IEA.

A possible Greek exit from the eurozone could suppress demand across the continent if economic activity was to weaken, the IEA said.

The agency said that would not translate into a “tighter market” for oil in 2016 as long as members of Opec, the oil producing cartel, continued to pump at near record levels.

“The group is not slowing down. On the contrary, its core Middle East producers are pumping at record rates and the outlook for Iraqi capacity growth — accounting for most projected Opec expansions — keeps improving,” it said.

Opec crude supply reached a three-year high in June to 31.7m b/d, up 340,000 b/d from the prior month, led by Iraq, Saudi Arabia and the UAE.

The IEA estimates that the demand for the cartel’s crude will stand at 30.3m b/d next year, up 1m b/d from 2015. But this is still a “whopping” 1.4m b/d less than its current production.

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